University MoneyHack #3

Reducing your student loan payments & whether you should pay off early

If you can’t afford your student loan payments or your combined total debt and housing payment is more than 40% of your take home income, you may want to discover ways to reduce your loan payments so your monthly cash flow is more controllable. You can read about the ratio in our last post “Tidying your student loan” here.

Reducing your monthly payments with a consolidation loan

As we mentioned in the last post, student loan consolidation can, in some cases, reduce your monthly payment and interest rate.

In the simplest terms, a debt consolidation loan will pay off your existing debts and transfer the money owed into one loan with one manageable, monthly repayment.

You will still have to pay back all the money owed, but with loan consolidation you may be able to reduce your monthly outgoings, pay a lower rate of interest, or be able to spread the costs out over a longer time period.

The Pros

  • Reducing your monthly payments — By spreading out the term of the debt you should be able to reduce your monthly repayments to a manageable level. Most people are often paying the ‘minimum payment’ allowed on the existing debts. This often just means covering the interest component of the loan while leaving the actual total amount owed unchanged.
  • Improving your credit rating — If you are able to pay off the loan and accrue no further debt, this will be seen as a positive impact on your credit rating. It is also a good idea to check your credit report before you apply for a debt consolidation loan.
  • Reducing the interest you pay — If your debts are with store or credit cards that have a high interest rate then you will generally pay back less interest on your debt with a loan.

And the danger…

You may find yourself getting into debt for a longer period than needed, so it‘s important to weigh up all the alternatives you could take to reduce your debts or help pay off your existing ones.

These loans should not be the first action to take against debt, especially if there are expenses and outgoings you can reduce or get rid of completely.

It’s worth analysing your budget and looking at what you can afford to pay back on your current debts first.

Paying off student loans early

Most people can’t wait until their student loans are gone entirely. While paying off your student loans early can save money and free up money in your monthly budget, it’s not always the best option.

Pros of paying off student loans early

Paying off your student loans early frees you from debt faster and provides a guaranteed return on your money by saving thousands of dollars in interest.
Let’s say you have a £10,000 student loan with a 10-year term at a 5 percent APR. If you make the 120 scheduled monthly payments of about £106, your loan will be paid off in 10 years and you will have paid roughly £2,728 in interest on top of the original £10,000.

If, however, you doubled your monthly payment to £212 from the beginning, you would pay off your loan in four years and five months and pay only £1,157 in interest. Doubling your payment gets you out of debt in less than half the time and for less than half the interest.

Cons of paying off student loans early

You can’t go wrong paying down your student loan debt early, but you only have so much money to spread over many different goals. Hanging onto your cash provides some benefits.

Money you use to pay down your student loans early is:

  • Money you cannot invest long-term in the stock market
  • Money you cannot save in case of an unexpected expense or job loss
  • Money you cannot save for a once-in-a-lifetime opportunity

Whenever you have an opportunity to pay down debt early, the first step is to look at the interest rate you’re paying. It’s always better to be earning interest than paying it, but the lower the interest rate, the less incentive you have to save or repay debt. You want to invest in high interest rates and borrow at low interest rates.

If for example, you have a student loan at 3.5% but can invest and earn 8%, the better mathematical play is to invest any spare money and take the 4.5% profit. Of course, paying down debt is a guaranteed return whereas investing involves risk. The choice is yours.

Personally, I think the better argument for not paying off student loans early is to hold onto your cash for other reasons.

Of course, hanging onto cash in a 1.15% APY savings account might not seem to make sense when you have student loan debt at higher rates, but cash provides you with the ability to whether financial setbacks and take advantage of financial opportunities. Cash provides an emergency fund to cover unexpected expenses without taking on more debt. Cash also enables you to take advantage of opportunities, whether they’re financial, such as starting a business, or personal, such as taking a sabbatical to travel the world for a month.

The point is, you’re only young once. If you’re smart and hard-working, you’ll pay off your student loan debt in due time.